On July 27, 2018, the Department of Finance announced draft legislation to amend the GST/HST holding corporation rules in section 186 of the Excise Tax Act (Canada) (“the ETA”), effective on and after July 27, 2018. This article summarizes the background, the proposed rules, and related considerations for corporate groups that rely on the rules in section 186 to claim input tax credits (“ITCs”).
For the most part, the proposed changes focus on subsection 186(1) of the ETA, which generally allows a holding corporation to claim ITCs in respect of GST/HST expenses where the holding corporation and another corporation are “related” as defined in subsection 126(1) of the ETA (“the Related Test”), and the GST/HST expenses can reasonably be regarded as having been acquired for consumption or use in relation to shares or debt of the related corporation (“Purpose Test”). All or substantially all of the property of the related corporation must also be for consumption, supply or use exclusively in the course of its commercial activities (“Property Test”). While both the holding corporation and the related corporation must be corporations, only the holding corporation is required to be resident in Canada and registered for GST/HST.
Over the years, the Canada Revenue Agency (“the CRA”) interpreted the Purpose Test in a manner that significantly limited the scope of subsection 186(1). For example, the CRA’s view as expressed in GST/HST New Memorandum 8.6, “Input Tax Credits for Holding Corporations and Corporate Takeovers”, November 2011, example #3, was that if a parent corporation raises capital by issuing its own shares in order finance the purchase of additional shares in a related corporation, related expenses would be “for consumption or use in relation to HoldCo issuing shares of its capital stock (the first order of supply) and not for consumption or shares in relation to the shares of [the related corporation]” as required to claim ITCs under subsection 186(1).
Practitioners and taxpayers generally took a broader view of subsection 186(1) based on the jurisprudence, including the Tax Court of Canada’s informal decision in Stantec Inc. V.R.,  G.S.T.C. 137 (TCC). In the absence of a binding decision from the courts on the scope of this provision (the Tax Court of Canada’s Act provides that an informal procedure judgement is not to be treated as precedent in any other case), the scope of subsection 186(1) remained the subject of dispute.
While the proposed changes address some of these issues, they go beyond clarifying the scope of the Purpose Test, and essentially replace it with a detailed set of rules. If the proposed legislation is enacted in its current form, ITC eligibility will no longer turn on whether the inputs “can reasonably be regarded” as being in relation to the shares or debt of a related corporation, but on whether the detailed and specific requirements of paragraph 186(1)(a), 186(1)(b) and 186(1)(c) are met.
Operating Corporation Test
In each case, in order for GST/HST expenses incurred by a holding corporation to be recovered under subsection 186(1), the “operating corporation” test must be met. These requirements are also found in the current version of subsection 186(1), but are being moved into a new provision under the proposed rules.
Pursuant to new subsection 186(0.1) of the ETA, a particular corporation (“Subsidiary”) qualifies as an “operating corporation of another corporation” if the following conditions are met:
1. The Subsidiary is “related” as defined in subsection 126(2) of the ETA to another corporation (“ the Parent”), and 2. All or substantially all of the property of the Subsidiary is property that was last manufactured, produced, acquired or imported by the Subsidiary for consumption, use or supply by the Subsidiary exclusively in the course of its commercial activities.
The test for when two corporations are “related” for these purposes is defined in subsection 126(2) and looks to whether the corporations are related pursuant to subsections 251(2) to (6) of the Income Tax Act (Canada). As discussed further before, the Department of Finance has requested comments on whether this test should be changed to a “closely related” test instead.
For purposes of determining whether an input is for consumption, use or supply exclusively in the course of commercial activities, the CRA’s view, as summarized in New Memorandum 8.6, supra, is that “‘exclusively’ generally means 90% or more for non-financial institutions and 100% for financial institutions.”
Under the proposed rules, the underlying expenses must also fall under one of new paragraphs 186(1)(a), 186(1)(b) or 186(1)(c) in order to qualify for ITCs. In brief, these provisions would allow ITCs to be claimed for expenses incurred in respect of a Subsidiary that meets the above Operating Corporation Test (“Qualifying Subsidiary”) in the following circumstances:
a) Proposed paragraph 186(1)(a) generally provides for ITCs on expenses incurred by the Parent to dispose of, obtain or hold, shares or indebtedness of a Qualifying Subsidiary, or on expenses incurred by a Qualifying Subsidiary to issue, redeem, convert or otherwise modify same.
b) Proposed paragraph 186(1)(b) generally provides for ITCs in relation to expenses incurred by the Parent to raise capital to the extent the proceeds are transferred for shares or debt to a Qualifying Subsidiary for use exclusively in the course of its commercial activities. The amount claimed under this provision would need to be pro-rated as appropriate if only a portion of the proceeds raised are transferred to a Qualifying Subsidiary or the Qualifying Subsidiary does not use the proceeds exclusively in the course of its commercial activities.
c) Proposed paragraph 186(1)(c) generally provides for ITCs in relation to expenses incurred by the Parent for the purpose of carrying on its activities if all or substantially all (generally understood to mean at least 90%) of Parent’s property is shares, or indebtedness of, Qualifying Subsidiaries unless (i) the expenses were incurred for activities that primarily relate to investments in entities other than Qualifying Subsidiaries, or (ii) the expenses relate to the making of an exempt supply by Parent, other than the financial services that are listed in clauses 185(1)(c)(ii) (A) to (E). The enumerated financial services generally include dealings in shares or debt of a Qualifying Subsidiary or Parent, guarantees in respect of same, the payment or receipt of related dividends or similar amounts, as well as underwriting of shares or indebtedness of a Qualifying Subsidiary.
Section 186 is an important provision, as businesses commonly operate through multiple legal entities, and Canada’s GST/HST regime does not have tax grouping or VAT grouping unlike other jurisdictions. In the absence of section 186 (and other relieving provisions), businesses that operates through multiple legal entities (and incur expenses in respect of non-GST/HST registered subsidiaries that engage in commercial activities outside Canada, for example) would routinely incur unrecoverable GST/HST.
The draft amendments are helpful in resolving long-standing disputes on certain types of costs, including expenses incurred by the Parent to raise its own capital to in turn invest in shares or debt of its subsidiary. At the same time, the proposed rules include new Purpose Test requirements, which raise new questions. For example, while proposed paragraph 186(1)(b) allows ITCs in relation to expenses incurred by the Parent to raise capital, this is only to the extent that the proceeds are transferred for shares or debt to a Qualifying Subsidiary for use exclusively in the course of its commercial activities. It is not clear in what timeframe this transfer of proceeds must occur, and what will be sufficient to meet the requirement that the proceeds be for use by the Subsidiary exclusively in the course of commercial activities.
Other Potential Changes to Section 186
Concurrent with the release of the proposed rules, the Department of Finance announced that it is considering whether the long-standing “related” test currently included in proposed subsection 186(0.1) of the ETA should be replaced with a “closely related” test, consistent with other GST/HST rules that require two corporations to be “closely related” to be treated as one person. This change would require 90% common ownership instead of 50% common ownership under the current rules and would significantly reduce the scope of subsection 186(1).
Also, the rules in section 186 currently only apply where both the parent and related person are corporations. The Department of Finance is considering whether these rules should be expanded to partnerships and trusts.